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Your single worst investment bias

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Published: Dec 28, 2012 9:15 a.m. ET

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What's the single most dangerous investment bias you have?

Probably, it's the very reason you are reading this article right now. You want to hear a story.

We all love stories. That's what keeps Hollywood in business. If we truly loved factual analysis over narrative, we'd sit around all day reading almanacs and reviewing PowerPoint slideshows. Webinars would be oversubscribed.

Powerful stories are literally all around us. It's how brand marketing works, for instance. When we "buy in" to a given name brand, we buy the story of our own intelligence for making the selection over another, or a generic choice. We make up a personal story.

Even when we analyze a product decision, brand intrudes. We seek to know the experiences of small numbers of others with the product (anecdotes) over, say, multi-year performance records or warranty claims (data).

Of course not. But a big step forward in your own retirement investing life would be to recognize the difference between stories and facts, and to fully grasp the investment bias you feed by falling into the story trap.

‘Hut’

The linguistics professors often use this example: A teacher walks into a classroom. He writes the word "hut" on the board. He turns to the class and says nothing.

In a few minutes, the students get nervous. They dislike the challenge of silence. The begin to debate the professor's apparent test of their intelligence.

Then, something funny happens. Some of the students begin to talk about huts. What kinds there are. Where you might find them. The advantages and disadvantages of living in one.

Others, however, start to make up stories. Indigenous villages. Surf vacations. Jungle tribes.

There you have the break in our mental measure of the world: In reaction to a concept, you can either quantify it (analysis) or qualify it (narrative).

Pitching the narrative

Wall Street sells narrative, hands down. The sales force understands it. The customers like it. Brokers need to be able to tell the "story" of a company to move shares. If the story is not so great, then they have to come up with a "story" about the sector, how things are changing in a way that will benefit the stock in question.

Failing that, the story is the economy itself. Things are turning positive (or negative). This company is very likely to benefit (or suffer) as a result of the economic story unfolding.

Unfortunately for us as investors, our natural investment bias means we love those stories.

A wise person once said, "The plural of anecdote is not data." Yet we fall for this particular investment bias, over and over, in our approach to the markets.

If one person suggests it might be time to go long on a given stock, well, that's an opinion. We hear it from another, and it's a trend. A third person agrees and, heck, now we're dealing in facts! Time to buy!

How can you avoid this investment bias? One way is to really dig in and become a full-time, facts-driven investment analyst. The billionaire investors of the world, such as Warren Buffett, are not simply lucky. They study data in reams. They make exceedingly few investments. When they invest, they invest big in a small number of stocks.

And, frankly, they bargain. At least some of Buffett's performance comes from buying assets from truly desperate people. He strikes deals for himself that essentially no one can equal. He has the cash to do that and you don't.

Another way is to buy exchange-traded funds (ETFs) that hold hundreds, even thousands, of stocks. At that level, the stories recede. By building a portfolio with a variety of asset classes, you get exposure to investments that often will move in contrary directions.

As one sector gains ground, for whatever reason, you get to sell a portion and buy the assets that are suddenly cheaper in comparison. It's how the big university endowments invest. It's how pension funds at major corporations work.

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